Foreclosure fraud fiasco could prolong housing depression

NEW YORK — Karl Case, the co-creator of a widely watched housing market index, was upbeat three weeks ago. Mulling the economy while at a meeting at a resort near the Berkshires, Case thought the makings of a recovery were finally falling into place.

“I’m a 60-40 optimist,” he said at the time.

Additional Photos

Realtor Dorothy Buse is seen in front of a foreclosed Kissimmee, Fla., home Wednesday. An announcement of an inquiry by up to 40 state attorneys general into banks’ use of flawed foreclosure paperwork could come as soon as today. The Associated Press

Today, Case’s mood is far more subdued. In scarcely two weeks, he and other housing analysts have watched as the once-staid world of back-office bank procedures has spawned a scandal that threatens to further unhinge the housing market.

On Friday, PNC and mortgage servicer Litton Loan Servicing joined those three financial institutions in suspending some foreclosures while they review how documents were handled. Bank of America, which had already announced a halt for 23 states, expanded the suspension to cover the whole nation. If other banks follow suit, it raises the specter of a national foreclosure moratorium.

In all, the banks will have to review the paperwork for hundreds of thousands of mortgages. On top of that, class action lawyers and state attorneys general have filed suits and urged foreclosure moratoriums.

In the near term, the freezes could actually benefit both homeowners and the housing market. Homeowners would have time to live rent-free and chip away at their debt. Prices might stabilize because so many homes are penned up.

But the long-term implications are grave. Only a month ago, housing watcher Mark Zandi, chief economist at Moody’s Analytics, predicted that a housing recovery would be under way by the third quarter of next year. Now he believes the foreclosure scandal could prolong the housing depression for at least another few years.

The alleged document fraud could open up the entire chain of foreclosure proceedings to legal challenge. Some foreclosures could be overturned, others deemed outright fraudulent.

A LEGAL CHALLENGE LOGJAM

Before a housing recovery can occur, all those foreclosed properties have to be re-scrutinized by the banks and then sold. With any foreclosure-related deal open to legal challenge, that inventory could be taken off the market while the legal challenges make their way through the courts.

That’s not to mention the questions being raised about missing paper trails on mortgages owned by people who have never missed a payment. What started as simple paperwork bungling in a Pennsylvania office park now threatens to bring to a standstill the nation’s entire foreclosure machinery.

The development is especially troubling given how large the foreclosure market is. Before the scandal erupted, forecasters at John Burns Real Estate Consulting predicted that 41 percent of home sales this year would be on distressed properties. Typically, distressed properties account for 7 percent.

Since housing is the engine that in the past seven recessions has pulled the economy out of recession, any further damage couldn’t come at a worse time.

“As far as I’m concerned, anything that slows the foreclosure process is a bad thing,” Case said last week.

The debacle injects yet more uncertainty into a frail recovery that is still trying to find its strength.

“This is definitely one of the last things anyone needed to have to deal with,” says Diane Pendley, managing director of Fitch Ratings.

The news that GMAC, recently renamed Ally Financial, and JPMorgan Chase and Bank of America were stopping foreclosure proceedings in 23 states was merely the beginning. Federal lawmakers are calling for a federal investigation, saying the excuses from the industry are not credible, and on Wednesday the Ohio attorney general filed a fraud suit against GMAC, calling it “the tip of an iceberg of industrywide abuse.” GMAC denies the allegations.

In at least six states, attorneys general are calling for foreclosure moratoriums and launching their own investigations. And this week, the attorneys general of up to 40 states are expected to announce a joint investigation into banks’ use of flawed foreclosure paperwork.

A person briefed on the investigation said over the weekend that an announcement of the 40-state investigation could come as early as today. The person spoke on condition of anonymity because the probe was not yet public. Iowa Attorney General Tom Miller will lead the inquiry.

The Obama administration is studying the situation. Problems with foreclosure procedures were discussed in two recent conference calls involving officials of the Treasury Department, the Department of Housing and Urban Development, the White House and other agencies, an administration official said on condition of anonymity.

A top White House adviser questioned the need Sunday for a blanket stoppage of all home foreclosures, even as pressure grows on the Obama administration to do something about mounting evidence that banks have used inaccurate documents to evict homeowners.

PRESSURE TO MOVE QUICKLY

“It is a serious problem,” said David Axelrod, who contended that the flawed paperwork is hurting the nation’s housing market as well as lending institutions. But he added, “I’m not sure about a national moratorium because there are in fact valid foreclosures that probably should go forward” because their documents are accurate.

Axelrod said the administration is pressing lenders to accelerate their reviews of foreclosures to determine which ones have flawed documentation.

“Our hope is this moves rapidly and that this gets unwound very, very quickly,” he said.

Lawyers who have already filed class action suits in Maine and Kentucky are now signing up entire neighborhoods as new clients. They’re hiring private eyes to track down former industry employees and holding marathon conference calls to strategize on how to get all the dirt on the banks that they can.

The low-level bank employees in question were supposed to have reviewed mortgage documents in detail. Instead, they say they never as much as glanced at the papers. Nor did they even know where the papers were.

“They were just so haphazard and so gloriously incompetent to save a few pennies here and there,” says Barry Ritholtz, director of equity research at Fusion IQ. “But a few pennies times millions of documents is a billion dollars.”

The banks insist that most of the people involved in the foreclosure deals were legitimately behind on their payments. But even so, if the procedures that put them into foreclosure are deemed fraudulent, it will nullify the deals and require that the entire process start all over again.

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